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March 07, 2011

Discretionary Capital Enforcement: A Bad Idea

Assistant Professor of Law Julie Anderson Hill of the University of Houston Law Center has spent some time looking through the publicly available formal capital enforcement actions taken by federal bank regulators from 1993 through 2010. Sure, it's a grind, but somebody's got to do it.

What Professor Hill has discovered from her empirical research will come as no surprise to community bankers: big banks fare better than community banks. Not a little bit better, a lot better. According to Professor Hill, "the data show a near complete absence of capital enforcement actions issued to the largest banks." Color me "not shocked."

Among Hill's other findings:

the number of capital enforcement actions has dramatically increased during the current economic downturn;

an increasing number of banks are subject to individual capital requirements – requirements that are higher than the requirements specified in statutes and regulations; and

the Federal Reserve is less likely than other regulators to bring serious capital enforcement actions and is less likely to increase capital requirements.

You can download a copy of the professor's study from the linked page above.

What Professor Hill argues, based upon these findings, is that while the regulators ought to retain some ability to issue discretionary capital enforcement actions and individual capital requirements, such ability should be exercised only in the case of a "small number of banks that are extraordinarily unique." She thinks that rule-making should be preferred over discretion because rule-making is "less costly, more transparent, and more likely to consider macro-economic concerns." Among the many arguments she makes in support of her views, one that especially strikes a chord with me is that when banks aren't certain what their capital requirements may be from year to year, it makes planning how to allocate capital impossible. As a result, many community banks are hoarding capital rather than using it to make loans. We see this daily in our practice.

Another argument that I found credible from personal experience is her skepticism of "regulatory ability" to set discretionary capital requirements on an institution-by-institution basis. That's a nice way of saying that it takes a great deal of sophistication and intellectual horsepower to "fine tune" capital requirements and that the horses you want to run that race aren't paddocked in the regulatory stable. Tellingly, she points to the abysmal performance of the regulators in anticipating the capital needs of banks prior to the onset of the current crisis and the very real probability that what we are seeing post-crisis may be an overreaction, an overreaction that results in too much capital being demanded at a time when the strings should be loosening, not tightening, in order to enhance the ability of banks to lend and of the economy as a whole to climb out of the hole in which it finds itself.

There is much more in the study than what I've touched upon, and I encourage interested readers to take a look at it. It's eminently readable, which will come as a shock to those of us who expect papers by academics to be as dense as Charlie Sheen's skull. In addition, it's always nice to have some research performed by someone with a cerebrum larger than your own to back up what your practical experience is telling you is the case.